Trade tensions may still dominate the headlines, but for markets in 2025, it’s the steady climb in U.S. bond yields that’s becoming the real story. With BCA Research estimating the effective tariff rate in the U.S. to near 15% – its highest level since the 1930s – trade barriers remain in the spotlight, yet it could possibly be the bond market that now poses a more serious threat to global financial stability.

The rise in yields is being driven not by stronger growth expectations, but by widening term premia – the extra return investors require for holding longer term bonds instead of rolling short-term bonds. This shift reflects rising concern over the long-term sustainability of U.S. fiscal policy, as investors demand compensation for what they increasingly see as a deteriorating debt outlook.

If the expiring provisions of the 2017 Tax Cuts and Jobs Act are made permanent, the Congressional Budget Office (CBO) projects that U.S. net government debt could soar from 98% of GDP in 2024 to 149% by 2040, while annual interest payments could rise from 3.1% to 5.3% of GDP. These estimates are likely understated, as they exclude additional tax cuts currently being discussed. 

The long-term implications of rising debt have been on investors’ radars for years, but with yields now reacting in real time, these risks are moving from theoretical to tangible. Term premia are repricing duration risk – applying upward pressure on long-end yields regardless of near-term macro data. Fiscal deterioration is no longer an abstract concern – it’s increasingly embedded in the structure of the U.S. yield curve.

For currency markets, the consequences are likely to be material. The U.S. dollar, historically buoyed by its safe-haven status and rate differentials, now faces a more uncertain path. Relatively higher yields may continue to attract flows in the near term, but if concerns around fiscal discipline intensify, the dollar’s defensive appeal could weaken – especially relative to currencies underpinned by more stable debt dynamics or healthier external balances. The bond market is becoming a dominant force in FX pricing, and the balance of risks for the dollar is clearly shifting.

As BCA Research notes, markets initially welcomed the pivot from tariffs to tax relief. But that optimism may soon fade. Rising debt-servicing costs in the U.S. and structurally higher term premia could ultimately prove more destabilising than the trade war headlines that once drove market sentiment. The fiscal outlook is now front-and-centre and currencies are beginning to reflect it.

The Dollar Faces a Structural Test

For currency markets, this fiscal dynamic has significant implications. The U.S. dollar’s countercyclical strength could weaken if bond vigilantes push yields higher and force a repricing of U.S. debt risk. BCA notes that while the Federal Reserve could, in theory, step in to cap yields, it is unlikely to do so unless the 10-year Treasury rate climbs to around 6% – a level that would almost certainly tip the economy into recession.

BCA maintains a bearish view on the dollar in the near term. However, the team acknowledges the dollar’s historical resilience during global risk-off episodes and remains open to shifting back to a neutral stance later in the year, particularly if market volatility returns or if yield pressures ease.

A Narrowing Window for Non-U.S. Assets

Outside the United States, the valuation picture is more attractive, but risks remain. Euro area assets, for example, are trading at strong multiples against U.S. assets, some slightly above their 10- and 20-year averages. 

In macro terms, much of Europe’s first-quarter economic resilience stemmed from tariff front-running, as businesses rushed to complete shipments ahead of anticipated U.S. trade actions. This temporary boost is expected to fade. Compounding the challenge, major euro area economies (France, Spain, Italy, and Belgium) are already burdened with public debt levels exceeding 100% of GDP, limiting the scope for further fiscal stimulus.

As a result, BCA expects that the recent outperformance of non-U.S. assets and currencies – driven largely by optimism and valuation expansion – will likely reverse. These markets are expected to decline and align more closely with the weaker performance of U.S. markets later this year, especially if global economic growth continues to lose momentum.

Conclusion: Markets Are Watching the Wrong Risk

Trade policy may continue to dominate the political conversation, but it appears to be clear that the bond market holds the real power to disrupt global capital flows. Rising yields – driven by fiscal imbalances, inflation expectations, and investor scepticism – are quietly reshaping the macro landscape.

For FX markets, this environment points to greater volatility and a renewed focus on macro fundamentals. Currency trends may no longer be driven primarily by interest rate differentials, but instead by relative fiscal credibility and debt sustainability.

Market participates should consider shifting their focus from the noise of tariff disputes to the deeper signals coming from the U.S. bond market. While trade tensions may influence short-term market sentiment, it is the sustained rise in borrowing costs that could fundamentally reshape global investment flows – and, in turn, the trajectory of major currencies.

Contact David du Plessis or Evan May should you find this article insightful or if you want to discuss how we can assist your business  – phone 021 819 7804 or email dduplessis@wauko.com or emay@wauko.com.